Academic journal article Indian Journal of Economics and Business

An Empirical Investigation of the Arbitrage Pricing Theory in a Frontier Stock Market: Evidence from Bangladesh

Academic journal article Indian Journal of Economics and Business

An Empirical Investigation of the Arbitrage Pricing Theory in a Frontier Stock Market: Evidence from Bangladesh

Article excerpt


Although the existing literature of Arbitrage Pricing Theory (APT) on different categories of stock markets is vast, it is non-existent in the case of frontier stock markets (defined as very small capital markets). This paper fills this gap by investigating how APT performs in a frontier stock market. To address the common problem of multi-collinearity in macro variables, this study uses principal component analysis (PCA) as a robustness check on the previous results. The results confirm evidence of one significant macroeconomic factor in the Dhaka stock market- a frontier stock market of Bangladesh. This result is comparable to that of some emerging (larger than frontier markets) stock markets.

Keywords: Arbitrage pricing theory (APT), Capital-asset pricing model, Dhaka stock exchange (DSE), Principal component analysis, Principal components (PC), Efficiency market hypothesis (EMH) and Chen, Roll and Ross (CRR).

JEL : GIO, G12,G11, G24, G32


Markowitz's (1952) theory of Portfolio Diversification has been instrumental in paving the way for modern asset pricing models to measure risks associated with equity returns. Subsequently, Capital Asset Pricing Model (CAPM) has been developed by Sharpe (1964), Linter (1965) and Mossin (1966). The Arbitrage Pricing Theory (APT) proposed by Ross (1976, 1977), has come as an alternative to CAPM measure of risk-return. The progress of models especially the APT appears to be influenced by the macroeconomic factors that intuitively affect capital investment. Whether the APT stands empirical viability has been tested widely time and again hence there exists a dense literature e.g. Shanken (1982), Brown and Weinstein (1983), Chen (1983), Cho, Elton and Gruber (1984), Chen, Roll, and Ross (1986), Connor and Korajczk (1986), Burmeister and McElroy (1988), Lehman and Modest (1988), to mention but a few.

However, the literature is rather limited in that these theories especially the APT have been tested in large developed stock markets now and then. Though it is noted that the APT has already been tested in a few emerging markets e.g. in Pakistan, Turkey and Indonesia (among others) yet in the context of frontier stock markets, defined as less advanced and very small capital markets, the evidence is nonexistent. (1) The empirical test of APT in the Dhaka stock market would enable it to compare its performance in a Bangladeshi stock market with that of other stock markets around the world. Subsequently, it will have implications in investment decision-making for the capital markets of Bangladesh.

Thus, this study aims to fill the gap by investigating the APT in a rather small but rapidly developing stock market and in addition, contribute further evidence to the already existing literature of the empirical tests of APT. Dhaka Stock Exchange (DSE) is a premier stock market of Bangladesh which was incorporated in 1954. As of 2009 the total market capitalization (MC) of DSE amounts to USD19020.18 millions which approximately has a ratio of 1:0.21 as GDP to Market Capitalization. Similar ratios for other countries are shown in the table below:

Table 1 (2)
A Comparison of Market Capitalization Across a Range of
Different Stock Markets

Country      MC as a Percentage
                  of GDP (in %)

Bangladesh                   21
Hong Kong                525.36
India                     77.53
Malaysia                 104.96
Indonesia                 19.61
Pakistan                     49
USA                      102.01

Table I exhibits the small MC of DSE when compared to other stock markets in the region as well as in the world. The annual growth rate of MC in DSE was 135.28% in 2007 but somewhat subdued since then as a result of Global Financial Crisis. Consequently, in 2009 the growth rate of MC was 23.9%. In order to test the APT empirically, this study employs pre-specified macroeconomic factor approach developed by Chen et al. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.